You work for a large international oil company searching for oil off the coast of Australia, not too far from Melbourne. Your firm has acquired drilling rights, and you are contemplating your firm’s options.
The estimated drilling cost is $40 million. For simplicity, assume that if you drill at this site, there are two possible outcomes: either there is oil at the site or there is no oil. Based on the available data, your geologists assign a 20% chance that there is oil at the site (the site is “wet”). If there is oil, your geologists believe that the expected present value of a well in this location is $160 million. If there is no oil (the site is “dry”), assume that the value of the drilled site is $0.
- Should you drill at site?
- What is the expected monetary value of the optimal policy?
- How does the optimal decision change as the “wet” probability changes?
- What is the break-even probability?
Suppose you could find out definitively whether or not there was oil at this site, before deciding whether to drill. What is the most you would be willing to pay for this information?How does EV with perfect information change as “wet” probability changes?
Although you cannot resolve all the uncertainty about whether the site contains oil, you can gather some information. In particular, you can do seismic testing. In this procedure, one sets off explosives on the ocean floor and measures the seismic waves at other points on the ocean floor. From the seismic data, one can construct a 3D image of the subsurface geology and see if there are structures that may form an oil reservoir. Your geologists estimate that most (90%) of the wet sites have structures that can be detected by this seismic test. However many (60%) of the dry sites also have these structures.
- What is the probablity the site is “wet” if the site has these structures, i.e. what is P(Wet|Structure)?
- What is the probablity that the site is “wet” if the site does not have the structues, i.e. what is PWet|No Structure)?
- The seismic test costs $2.5 million. Do you want to do the test? Explain why or why not.
- How does EV of doing the seismic test first change as “wet” probability changes?
Now consider a second site. The second site would cost $40 million to drill, with the same assessment of the outcomes: a 20% chance of a value of $160 million (wet) and an 80% chance of $0 (dry). Because of the similarities between the two locations, the outcomes at the two sites are not probabilistically independent. In particular, if you knew that the first site was wet, that information would change your assessment of the probability that second one is wet from 20% to 60%. Similarly, if you knew that first site was dry, that information would change your assessment of the probability that second is wet from 20% to 10%.
- What is the probability that both sites are wet?
- What is the probability that both sites are dry?
- What is the probablity that one site is wet and the other is dry?
Hint:It may help to use a probablity tree.
Ignoring the possibility of doing the seismic test, should you drill the first site first and then drill the second one, drill both sites simultaneously or drill neither of these sites?
- Describe the optimal drilling strategy.
- Explain why you think this strategy makes sense.
As a result of the financial crisis on Wall Street in the fall of 2008, government intervened with a bailout bill. An investor was considering various strategies for her money and the estimated profits would depend on how successful the bailout bill would be in helping the U.S. economy. The estimated annual return for two different investment strategies are shown in the following table. Suppose there is a 30% chance that the economy will decline, 50% that there will be no change and 20% chance that it will rebound and it is possible to hire a fortune teller who can tell you (with 100% accuracy) how the economy would react. How much would you pay the fortune teller, i.e. what is the EVPI?